As we noted in the introduction of the study, proponents of raising state cigarette taxes usually advance two major arguments — discouraging smoking, and increasing state tax revenues. If cigarette tax hikes also depress legal cigarette sales and increase smuggling activity, however, lawmakers are faced with the question of how to balance these outcomes when deciding what cigarette tax policies to adopt.

Earlier, we discussed the extent to which raising state cigarette taxes would depress legal sales in Michigan, New Jersey and California (see "The Projected Effect of a State Tax Hike"). We'll use Michigan to illustrate what these declines mean for state revenue, which is one of the factors that policymakers will naturally consider.

Michigan Treasury figures for cigarette revenue show that approximately 571,473,000 packs of cigarettes were sold legally in the state in 2006,[211] the year on which our model's tax change projections are based. If the state of Michigan raised its cigarette tax by 25 cents per pack and other states did not change their cigarette taxes,[*] we would estimate a decline in legal sales of about 23,374,000 packs due to increased smuggling. The net result of this change, however, would still be a gain of about $90.3 million dollars to the state's coffers, since the size of the tax increase would more than compensate for the decline in the number of packs sold.

On the other hand, if the state of Michigan chose to cut taxes by 25 cents per pack, legal sales would increase by about 24,755,000 packs due to reductions in casual and commercial smuggling. In terms of state revenue, however, this increase in legal sales would not offset the decline in the per-pack tax rate, and we would estimate that state revenues would fall by approximately $99.5 million due to changes in smuggling.

Calculations of the effect on tax revenue for tax increases and decreases of 25 cents and 50 cents appear in Graphic 24. The revenue figures in Graphic 24 do not quite represent the total change in state tax revenue as a result in a change in the tax levied, since they do not include the effect of people reducing their smoking in response to a tax hike or increasing their smoking in response to a tax cut.[†] Nor do the figures include the impact on the revenue estimates of the general sales tax levied on cigarettes.

Note that the calculations for changes in state tax revenue assume that base cigarette consumption is approximately 560,774,000 packs annually.

Still, given the considerable impact of smuggling on state tax revenues, these numbers in Graphic 24 provide a fair picture of what a modest increase or decrease in state cigarette taxes will generally do. In most cases, an increase in the tax rate will increase state cigarette tax revenue and prompt a small decrease in overall smoking, but yield more consumption of smuggled cigarettes. Similarly, a decrease in the tax rate will result in less state tax revenue and a modest increase in overall smoking, but also produce less consumption of smuggled cigarettes.

At first blush, higher cigarette taxes might seem to yield more benefits and fewer costs than lower cigarette taxes. But looking closely at the question leads to a more complex answer.

The high and rising state cigarette taxes of recent years have considerably escalated the social cost of smuggling. Casual smuggling may not risk much more than a reduction in expected state tax revenues, especially with the convenience of Internet cigarette orders, but it still represents a loss of time and energy that a consumer might spend on something more productive.

The social costs appear to be higher with commercial smuggling, which has become a significant component of the modern-day black market in cigarettes. Commercial smuggling can yield enormous quantities of money, with a single semi-trailer shipment generating hundreds of thousands of dollars in revenue. Minor league commercial smugglers may earn thousands of dollars with a vanload of cigarettes for part-time work. With such sums at stake, the incentive to steal cigarettes and cigarette tax stamps intensifies, leading to new crimes of violence, including hijackings, breaking-and-entering, theft, robbery and even murder. Drivers, shopkeepers, innocent bystanders and police have been threatened and injured.

The profits from these activities not only help finance more commercial smuggling (and its ancillary violent crime); they also can help finance other illegal activities. Smuggling profits diverted to Hezbollah or to organized crime are unlikely to serve the interests of the people that policymakers are supposed to serve.

Ultimately, smuggling brings health risks, just as smoking does. While it is difficult to compare the two risks — the health effects of habitual smoking are well-known, and the crimes fueled by cigarette smuggling are harder to trace — it is clear that cigarette smuggling creates risks for innocent people. Victims of crime financed by the profits from cigarette smuggling may have no relationship to the cigarette industry or to the smugglers themselves.

Nor is it likely to serve society's interests to have people in the cigarette wholesale and retail industry face a serious risk of violent crime due to the smuggling trade. Many business owners who deal in cigarettes have been used to running their businesses like any company that handled similar merchandise, and they now find themselves facing the threat of armed robbery and other crimes. If they exit the industry to avoid the risk, legal cigarettes will become scarcer; if they raise their price to help pay for the risk, legal cigarettes will become more expensive. Both will result in further demand for smuggled cigarettes, strengthening the commercial smuggling industry. As in the era of alcohol prohibition, commercial smugglers, having already embraced criminal activity, will tend to be less concerned about the user safety of smuggled — possibly counterfeit — products. They will be more prone to violence. And as with narcotics prohibition, they will be less concerned about selling to underage consumers.

Increasingly pervasive smuggling — whether commercial, casual or Internet smuggling — will also tend to affect smoking cessation rates. Smokers who might have responded to higher taxes by quitting their habit may be less likely to do so as smuggling increases. A prevalence of illegal product will make it easier to find low-cost cigarettes, and an increased incidence of illegally purchased product could help habituate otherwise law-abiding smokers to engaging in illegal activity. Hence, one of the apparent benefits of raising cigarette taxes — a reduction in smoking — may decrease as cigarette taxes rise. As DeCicca, Kenkel and Liu have written, "[R]egardless of how large smoking's externalities are or internalities are, tax avoidance reduces the effectiveness of state excise taxes as a corrective policy tool. ..."[212]

The other apparent benefit — an increase in state tax revenues — may also decrease as cigarette taxes rise. Our model suggests that increases in illegal cigarette purchases will lead to diminishing returns in enhancements to state revenue; as Graphic 24 shows, both a 25-cent tax hike and a 50-cent tax hike will increase state revenue, but the 50-cent tax hike falls short of raising twice as much as the 25-cent tax hike. This result is due to increased tax avoidance and smuggling; it is not due to the greater reduction in smoking caused by the higher 50-cent tax (smoking cessation is not included in the calculations, though it is unlikely to change them significantly).[‡]

At particularly high tax levels, it is even possible that cigarette tax revenues will decline with a cigarette tax increase. As noted earlier, New Jersey's recent tax increase gave it the nation's highest state cigarette excise tax, but for the next two years, actually left the state with less cigarette tax revenue than it had before.

It is also worth considering how state cigarette revenue is spent. Proponents of high cigarette excise taxes argue that smoking addiction leads to higher medical costs that general taxpayers are forced to subsidize through taxes for Medicaid. This argument was used in the 1990s when many state attorneys general began suing tobacco companies for compensation for health care costs allegedly imposed on the states by residents' cigarette use. The settlements that resulted from those lawsuits, including the Master Settlement Agreement, resulted in tobacco company payments to the 50 states totaling more than $243 billion in the first 25 years.[213]

State governments have used the money for everything from public school finance to defending Los Angeles city police officers from lawsuits stemming from alleged abuse.[214] Michigan, the state whose tax revenues were considered above, has used its MSA money for college scholarships; for state economic development programs;[§] for a Forest Finance Authority; for promoting the film industry in Michigan; for advertising for Michigan's tourism industry; and for a lump sum payment of $400 million[215] in securitized revenues in 2006. The advocacy group Tobacco Free Kids reported that in fiscal 2007 Michigan spent nothing on tobacco prevention programs. In fiscal 2008, the group found that the state registered a $3.6 million expenditure on such programs, about 6.6 percent of the Center for Disease Control's recommended minimum.[¶]

Much of the spending of the MSA money in Michigan and elsewhere has not dealt with Medicaid costs or smoking prevention — a disconnect with the purported purpose of the original lawsuits. Rather, the spending has been used for a variety of programs meant to benefit the general public. The same is true of much of the revenue from Michigan's cigarette excise tax.

Yet it is generally considered poor tax policy to fund general purpose programs using revenues raised from only a minority of the population, such as smokers. Such policies prevent the general public from appreciating the full cost of the benefit it receives and can encourage a majority of voters to overtax a minority. This may be especially worth remembering given that cigarette taxes, which are based on a percentage of the price, are inherently regressive, meaning that they fall more heavily on the poor. Indeed, DeCicca, Kenkel and Liu note that cigarette tax evasion increases with income level, meaning that cigarette taxes may be more regressive than usually recognized.[216]

[*] The model is based on the differences between a state's cigarette taxes and the cigarette taxes of other states. Hence, the model will generate considerably different results from the ones in the text above if we assumed that all of Michigan's bordering states increased their taxes by the same amount and at the same time Michigan did. In that (unlikely) case, the net change in smuggling would probably be small and limited to Indian reservations.

[†] An increase in smoking due to a tax cut may include some cigarettes smoked by new smokers, but it will also include the additional cigarettes smoked by existing smokers. Similarly, in a tax increase, some of the reduction in total cigarette consumption may include a reduction in cigarettes due to a reduction in the number of smokers, but it will also include the reduction in cigarettes smoked by existing smokers.

[‡] In fact, including the effects of higher taxes on the consumption of cigarettes could bring the estimated tax revenues for the two tax hikes even closer together.

[¶] "A Decade of Broken Promises: The 1998 State Tobacco Settlement, 10 Years Later: Michigan," Tobacco Free Kids, http://www.tobaccofreekids.org/reports/settlements/print.php?stateID=MI (accessed August 18, 2008). Michigan and other U.S. states are not alone in this behavior. A 2008 report from the World Health Organization says, "In countries with available information, tobacco tax revenues are more than 500 times higher than spending on tobacco control. In low- and middle-income countries, tobacco tax revenues are more than 9000 and 4000 times higher than spending on tobacco control, respectively."